Arcotia Hatsidimitris - International Tax Dialogue

26 – 2. SELECTING THE RIGHT CASES
Business understanding and risk identification
There are two principal approaches to risk assessment. Tax administrations need to consider both
of them.
Bottom up – this involves consideration of information about the cross border arrangements that
are specific to the MNE and jurisdiction in question, especially those that are not commonly found in
transactions between unrelated parties and that may distort the allocation of profits and losses between
jurisdictions. Tax administrations need to be satisfied with any analysis submitted that seeks to
demonstrate that these arrangements are on arm’s length terms.
Top down – this involves an assessment of the profitability of the group’s operations in the
jurisdiction in the context of the overall profitability of the MNE group, taking into account the
allocation of functions, assets and risks and the business sector in which it operates. If the profitability
of the company falls significantly below expectations based on high-level economic analysis, further
investigation of the reason for this and the pricing of significant transactions is required.
Both approaches are dependent on a good commercial understanding of the company, the MNE
group and the sector. This can be built up from published sources and, where an enhanced
relationship exists, from discussions with the leadership of the MNE group itself 6 . Understanding the
specific business context in which related party transactions are being conducted is of critical
importance, as is an appreciation of the results of the business in a particular country in the context of
the overall MNE group. Commercially available databases, like Amadeus, that bring together the
reported results of many companies and provide information about key financial ratios and sectoral
variations are used by several countries to identify risk and inform their risk assessments.
Although information from these sources can be valuable in providing potential comparables
within sectors and can therefore help to refine the risk assessment process, advisers emphasised the
need for tax administrations to develop an understanding of the specific business model of each
taxpayer. They noted that tax administrations do not always place enough emphasis on the need to
achieve a good understanding of how a business is run before focusing on specific transactions. This
view was echoed by tax specialists working in business. These specialists particularly emphasised the
importance of understanding the business functions undertaken by different parts of a group of
companies and how those interact before entering into detailed examination of specific aspects. The
internal management of MNEs is commonly more concerned with functions and product lines than the
specific legal entities through which they operate.
Business, their advisers and tax administrations all emphasised the importance of understanding
the operations of an MNE, their sector and the economic context in which they operate including the
impact of the present, difficult economic climate. This is an approach that many considered even more
important when the business cycle exhibits exceptional swings and trading conditions that are very
different to anything most have experienced before.
The use of specialists is dealt with more comprehensively in Chapter 7, but they have a part to
play in effective risk identification. Many tax administrations use general tax auditors or tax inspectors
to undertake the initial risk assessment, but a number also involve specialists to help make the finely
balanced judgements required in identifying and assessing risk. For example, some tax administrations
have developed a cadre of sectoral experts who have a good understanding of key sectors, such as
banking, or the pharmaceutical industry. Advisers see sectoral specialisation as a positive
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